Hong Kong SFC Issues Clarification on Standards Expected of Asset Managers

October 04, 2017

The Hong Kong Securities and Futures Commission (SFC) recently released a circular outlining its views on how asset managers should address certain conflicts of interest between private funds and separately managed accounts and avoid practices that undermine market integrity (Circular). The Circular sets out several examples of inappropriate conduct on the part of asset managers and informs the industry of the relevant standards expected by the SFC. 

SFC Guidance 

The SFC’s guidance is directed principally at private fund managers or other managers running discretionary accounts – private vehicles are more likely than retail funds to hold interconnected investments that are concentrated or illiquid and which the SFC seems to view as raising concerns. 

In particular, the SFC has observed: failures of asset managers to act in the best interest of the integrity of the market; failures to act fairly and to avoid conflicts of interest; and inadequate or improper risk management measures adopted by asset managers. While some of these practices are clearly prohibited under existing SFC codes of conduct, the SFC’s guidance highlights certain practices that will no doubt be under heightened scrutiny. In particular, the SFC considered the following practices as “irregular”: 

Failure to Act in the Best Interests of the Integrity of the Market 

The SFC highlighted the following situations as failure to act in the best interests of the integrity of the market: 

  • Where managed accountholders have investment discretion over the accounts and hold sizeable concentrated stock positions in such accounts. In these cases, asset managers act solely at the direction of their clients without exercising investment discretion; 
  • Purchases or sales of listed company shares by related parties, either through notes, or via funds or discretionary accounts controlled or influenced by related parties (e.g., substantial shareholders, directors or affiliates); and 
  • Where a director of an asset manager also acts as the director or chief executive officer of listed companies in which the asset manager invests funds. 

Inadequate or Improper Risk Management Practices 

Certain funds and discretionary accounts are heavily invested in concentrated positions in illiquid stocks and/or stocks issued by a network of smaller interconnected listed companies. The following situations are of particular concern to the SFC: 

  • Where an asset manager’s funds or accounts hold approximately 5% of the issued shares of a listed company; and 
  • Where the asset manager does not have appropriate and effective management policies to address concentration and liquidity related risks. 

Failure to Act Fairly and to Avoid Conflicts of Interests 

The following situations are of particular note: 

  • Where the asset manager lends capital from one fund it manages to another fund it manages in order to meet margin call obligations, or arranges for a related party to lend to a fund managed by the asset manager with an excessive one-off financing charge; and 
  • Where the asset manager gives preferential treatment to an investor in a related fund by allowing such investor to redeem its holdings before making any negative adjustment to the fund. 

What Should Asset Managers Consider? 

The SFC warns that it will closely supervise asset managers and will take enforcement action for failure to comply with regulatory requirements. Boards and senior management of asset managers should bear in mind that they are expected to maintain adequate oversight of their firms’ business activities, and that they are primarily responsible for maintaining the appropriate standards of conduct. Management is advised to review firms’ current policies for compliance with the following guidelines proposed by the SFC: 

  • Asset managers should not accept questionable arrangements and transactions proposed by their clients that seem to lack commercial substance. If necessary, asset managers should perform proper client due diligence and avoid engaging in market misconduct or practices that conceal the shareholdings of fund investors or discretionary accountholders in listed companies. In fact, asset managers have an affirmative duty to report to the SFC when they reasonably suspect that their clients may have committed any material breach, infringement or non-compliance with the market misconduct provisions of the Securities and Futures Ordinance. 
  • To avoid potential conflicts of interest, asset managers should exercise due care when investing in stocks where their fund investors, discretionary account holders, directors or their own key personnel may be privy to material non-public, price-sensitive information. 

Asset managers should have in place and maintain effective risk management policies and procedures to identify and manage the risks to which each fund or discretionary account is or may be exposed. An important aspect is the management of liquidity risks, as asset managers should endeavor to ensure that they are able to meet investors’ redemption requests in accordance with the terms set out in the funds’ offering documents. Undue concentration of illiquid or interconnected stocks, especially if coupled with the use of leverage, should be carefully reviewed.

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